Degree of Financial Leverage (DFL)

DFL Formula Breakdown (Step-by-Step)

A more detailed calculation of DFL is comprised of the following five steps.

• Step 1: Multiply Quantity Sold by (Unit Price  × Variable Cost Per Unit)
• Step 2: Subtract Fixed Fixed Costs from (1) → Numerator
• Step 3: Multiply Quantity Sold by (Unit Price  × Variable Cost Per Unit)
• Step 4: Subtract Fixed Costs and Fixed Financial Costs from (3) → Denominator
• Step 5: Divide the Numerator (Step 2) by the Denominator (Step 4)

If we combine those steps into a formula, we are left with the following.

Where:

• Q = Quantity Sold
• P = Unit Price
• V = Variable Cost Per Unit
• FC = Fixed Costs
• I = Interest Expense (Fixed Financial Costs)

Degree of Financial Leverage Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Degree of Financial Leverage Calculation Example (DFL)

Suppose we have two virtually identical companies with just one exception — one is an all-equity firm whereas the other company has a capital structure with a mixture of debt and equity.

• All-Equity Firm: No Debt
• Debt-Equity Firm: $50 million Debt @ 10% Interest Rate

In Year 1, the two companies both brought in $10 million in operating income (EBIT).

As for Year 2, we’ll assess the degree of financial leverage under two cases.

• Positive Growth: Year 2 EBIT Increases by 50%
• Negative Growth: Year 2 EBIT Declines by 50%

That being said, the Year 2 EBIT values are as follows.

• Positive Growth: Year 2 EBIT = $15 million
• Negative Growth: Year 2 EBIT = $5 million

The next step is to calculate the pre-tax income, which requires deducting the annual interest expense.

For the all-equity firm, the pre-tax income is equal to EBIT because there is no debt in the company’s capital structure.

But for the debt-equity firm, the interest expense is equal to the $50 million in debt multiplied by the 10% interest rate, which comes out to $5 million.

• Interest Expense = $50 million × 10% = $5 million

The $5 million interest expense can be extended across the two-year periods in both scenarios, as interest is a “fixed” cost, i.e. whether the company performs well or underperforms, the interest due remains unchanged.

The final line item to deduct from pre-tax income before reaching net income is taxes, which we’ll assume is equal to zero for the sake of isolating the impact of leverage.

After that, we’ll calculate the % change in net income and % change in EBIT — the two inputs in our DFL formula — for all four sections.

• % Change in Net Income = (Year 2 Net Income ÷ Year 1 Net Income) – 1
• % Change in EBIT = (Year 2 EBIT ÷ Year 1 EBIT) – 1

If we divide the % change in net income by the % change in EBIT, we can calculate the degree of financial leverage (DFL).

All-Equity Firm

• Positive Growth: DFL = 50% ÷ 50% = 1.0x
• Negative Growth: DFL = –50% ÷ –50% = 1.0x

Debt-Equity Firm

• Positive Growth: DFL = 100% ÷ 50% = 2.0x
• Negative Growth: DFL = –100% ÷ –50% = 2.0x

From our illustrative example, we can see when a company exhibits positive growth in EBIT, debt financing contributes towards greater net income growth (1.0x vs 2.0x).

However, the same impact is seen under negative growth, just in the opposite direction (i.e. the leverage causes greater losses).

Therefore, companies must be cautious when adding debt into their capital structure, as both the favorable and unfavorable effects are magnified.